Risk and Tax Considerations - Introduction
Of the 250 questions on the Series 7 exam, 70 will focus on the critical function: "Provides customers and prospective customers with information on investments and makes suitable recommendations", as indicated by the FINRA's Content Outline for the General Securities Registered Representative Exam.
Risk can be broadly defined as the degree of uncertainty that an instrument will earn its expected rate of return. There are several different types of risk:
- Inflationary: this is the risk that investment returns fail to keep pace with inflation over long periods of time. Bond holders are most susceptible to this type of risk.
- Capital: this is the risk that one may lose some or all of one's investment. The reasons could be numerous.
- Timing: applicable to most any investment, timing risk can occur upon purchase or sale. This type of risk speaks more broadly to valuation and risk management. At some point, some investors will be of the opinion that a certain price point would be the one at which to buy or sell a particular investment. Company-specific, as well as systemic risks, are both price determinants.
- Interest Rate: specific to bondholders and bond traders, interest rate risk impacts bond prices when rates fluctuate. Prices and rates have an inverse relationship. An increase in the latter causes a decrease in the former. The longer the bond's maturity and duration (the weighted average term to maturity of a bond's cash flows, a common risk metric of how quickly the creditor will be repaid), the more susceptible it is to interest rate risk. However, for investors who choose to hold the bond to maturity, such fluctuations are of no consequence, as they continue to receive the coupon and eventually will receive the principal in its entirety.
- Market/Systematic: this is the risk embedded in financial markets that cannot be diversified away completely, only mitigated.
- Credit: this is the risk that a company's financial difficulties may impede its ability to satisfy its obligations, causing the yield on its fixed income obligations to rise.
- Liquidity: applicable to thinly traded domestic securities (e.g., pink sheet stocks with wide bid/ask spreads), private investments (all manner of private placements, debt and equity) that avoid public markets altogether, private equity, hedge funds, real estate (publicly traded REITs being an exception) and complex structured products that are hard to value, such as credit derivatives (various iterations of the Collateralized Debt Obligation). Liquidity risk is that which impedes the ability to dispose readily of an investment at the current market price (which may be difficult to determine) in an arm's length transaction.
- Political: this is the risk that the political process through legislation, governmental fiat or gridlock, could impair returns on one's investments or obviate them altogether. Some examples are when a foreign government nationalizes an industry or promulgates a law that would adversely impact an industry, affecting its profitability. The summer 2011 debt ceiling fracas in the United States that caused a decline in the creditworthiness of its paper, is a more recent example. So, too, are the problems surrounding monetary union in the eurozone where the presence of monetary union, but lack of fiscal union and its attendant problems, have cause yields on sovereign debt of eurozone countries, such as Greece, Italy and Spain, to spike. Political risk can affect equity and fixed income alike.
- Call: this risk is specific to bondholders. When an issuer has a call provision written into the bond's indenture, it reserves the right to call the bond away when interest rates decline, so as to be able to refinance its debt as a lower interest cost. This benefit to the issuer is a risk to the creditor (lender), as it creates reinvestment risk.
- Currency: a risk to individuals who invest in foreign equities and fixed income. The fluctuation of the foreign currency relative to the one in which the investor reports returns, could either benefit or detract from that investor's total return (currency returns and capital gains or losses). As an example, when the investor's currency purchases more units of a foreign currency, that investor is receiving more foreign units per domestic one, relative to a previous time period. As a rule, with reference to the currency in which the investor reports returns, the stronger it is relative to the foreign one, the lower the return; the converse is true when the reporting currency is weak. Currency strength or weakness is a function of fiscal and monetary policy and trade competitiveness.
- Reinvestment: a corollary to call risk, reinvestment risk comes about when a bond is called away, leaving the investor with the task of finding a comparable yield at which to reinvest his or her cash.
- Business: this is a risk of a downturn in a business due to factors unique to it;aA manufacturer loses a major supplier, for example. The impairment could be temporary or permanent.